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Friday, October 12, 2012

Do You Know Your Cost of Capital? - Harvard Business Review

With trillions of dollars in cash sitting on their balance sheets, corporations have never had so much money. How executives choose to invest that massive amount of capital will drive corporate strategies and determine their companies’ competitiveness for the next decade and beyond. And in the short term, today’s capital budgeting decisions will influence the developed world’s chronic unemployment situation and tepid economic recovery.

Although investment opportunities vary dramatically across companies and industries, one would expect the process of evaluating financial returns on investments to be fairly uniform. After all, business schools teach more or less the same evaluation techniques. It’s no surprise, then, that in a survey conducted by the Association for Financial Professionals (AFP), 80% of more than 300 respondents—and 90% of those with over $1 billion in revenues—use discounted cash-flow analyses. Such analyses rely on free-cash-flow projections to estimate the value of an investment to a firm, discounted by the cost of capital (defined as the weighted average of the costs of debt and equity). To estimate their cost of equity, about 90% of the respondents use the capital asset pricing model (CAPM), which quantifies the return required by an investment on the basis of the associated risk.

But that is where the consensus ends. The AFP asked its global membership, comprising about 15,000 top financial officers, what assumptions they use in their financial models to quantify investment opportunities. Remarkably, no question received the same answer from a majority of the more than 300 respondents, 79% of whom are in the U.S. or Canada. (See the exhibit “Dangerous Assumptions.”)

Dangerous Assumptions

That’s a big problem, because assumptions about the costs of equity and debt, overall and for individual projects, profoundly affect both the type and the value of the investments a company makes. Expectations about returns determine not only what projects managers will and will not invest in, but also whether the company succeeds financially.

Say, for instance, an investment of $20 million in a new project promises to produce positive annual cash flows of $3.25 million for 10 years. If the cost of capital is 10%, the net present value of the project (the value of the future cash flows discounted at that 10%, minus the $20 million investment) is essentially break-even—in effect, a coin-toss decision. If the company has underestimated its capital cost by 100 basis points (1%) and assumes a capital cost of 9%, the project shows a net present value of nearly $1 million—a flashing green light. But if the company assumes that its capital cost is 1% higher than it actually is, the same project shows a loss of nearly $1 million and is likely to be cast aside.

Nearly half the respondents to the AFP survey admitted that the discount rate they use is likely to be at least 1% above or below the company’s true rate, suggesting that a lot of desirable investments are being passed up and that economically questionable projects are being funded. It’s impossible to determine the precise effect of these miscalculations, but the magnitude starts to become clear if you look at how companies typically respond when their cost of capital drops by 1%. Using certain inputs from the Federal Reserve Board and our own calculations, we estimate that a 1% drop in the cost of capital leads U.S. companies to increase their investments by about $150 billion over three years. That’s obviously consequential, particularly in the current economic environment.

Let’s look at more of the AFP survey’s findings, which reveal that most companies’ assumed capital costs are off by a lot more than 1%.

The miscalculations begin with the forecast periods. Of the AFP survey respondents, 46% estimate an investment’s cash flows over five years, 40% use either a 10- or a 15-year horizon, and the rest select a different trajectory.